The industry minister, Margaret Hodge, yesterday provoked a furious reaction from politicians and refugee groups by proposing that local British-born families should get priority for scarce social housing over newly arrived immigrants, with the exception of refugees.

Her comments in yesterday's Observer brought strong criticism from fellow Labour MPs and the Liberal Democrats and were used by the Conservatives to argue for stronger controls over immigration. Mrs Hodge represents Barking, an east London constituency which was once mainly white working class and is now a racially diverse area. Most of the council housing has been sold under the right to buy and the area has been a target for the British National party, which gained 11 seats on the local council last year.

Mrs Hodge wrote yesterday that the government "prioritised the needs of an individual migrant family over the entitlement that others feel they have to resources in the community. So a recently arrived family with four or five children living in a damp and overcrowded privately-rented flat with the children suffering from asthma will usually get priority over a family with less housing need who have lived in the area for three generations and are stuck at home with the grandparents." She continued: "We should look at policies where the legitimate sense of entitlement felt by the indigenous family overrides the legitimate need demonstrated by the new migrants."

Mrs Hodge advocated drawing up new rules based on such factors as citizenship, the length of residence and national insurance contributions. But the Labour MP for Hayes and Harlington, John McDonnell, who tried to challenge Gordon Brown for the Labour leadership last week, said: "This is a deeply reactionary and dangerous statement to make. The issue, however, is not the allocation of housing, but the chancellor's failure to allow affordable house building over the last 10 years - resulting in the present housing crisis."

Jon Cruddas, MP for Mrs Hodge's neighbour seat of Dagenham, and a deputy leadership candidate, said: "We're in danger of racialising arguments over housing allocation rather than concentrating on the need for greater social housing provision."

The Liberal Democrat local government spokesman, Andrew Stunell, said: "There are one-and-a-half million families on the council housing waiting list and the Labour government keeps selling houses off. The first thing to do is start building social housing again, not to blame immigrants for the catastrophic government failure to tackle the issue."

The Conservative immigration spokesman, Damian Green, said: "Margaret Hodge is admitting the long-term failure of this government to control immigration. This is why Conservatives are calling for an explicit annual limit on the numbers coming here from outside the EU so that we can avoid exactly the sort of problems she is talking about."

Nancy Kelly, of the Refugee Council, also hit out at Mrs Hodge's comments, saying: "The way to counter some of the views that are put forward by the far-right parties is not by trying to follow their lead." Ms Kelly stressed that asylum seekers were not entitled to council housing and arrivals from new EU states had restricted access to benefits.

"People who are recognised as refugees are entitled to council housing but on exactly the same basis as a UK national, on the basis of need," she said.

Mrs Hodge said last night that she had been misinterpreted by critics, as she both backed an increase in social housing and wanted refugees excluded from any restrictions.